Economic forecasters sometimes describe capital markets as a leading economic indicator, which assumes that share prices of equity securities anticipate good or bad economic conditions: Share prices rise when investors expect economic growth, and fall when economic recession is expected; or so the conventional wisdom says.
But can capital markets actually create or destroy the very economic conditions that their participants are anticipating? Isn’t this the purpose of a “capital market,” to facilitate the buying and selling of securities (equity or debt), in the interest of raising capital for corporate and government objectives, which is usually to finance growth of the respective enterprises?
Are the participants in capital markets (investors) buying or selling in anticipation of future economic conditions AND thus contributing to the anticipated economic condition? Do capital markets have an inherent self-fulfilling prophecy effect? Do capital markets create their own fuel?
These are not rhetorical questions. I would like some education. I’m a CFP with an MBA but certifications and degrees don’t help me (or anyone) as much as the study of philosophy, which makes me fully aware of my own ignorance.
So please read a bit more and share your wisdom with me and others in the comments"¦
The idea for this post, and thus the inspiration for the questions I’d like for you to answer, came from a statement made by Alan Greenspan this past Sunday on Meet the Press (full transcript here):
“…as I’ve always believed, we underestimate the impact of stock prices on economic activity. Asset prices are having a profoundly important effect. What created the extent of the contraction globally was the loss of $37 trillion in market value. It collapsed the value of collateral in the system and it disabled finance. We’ve come all the way back–maybe a little more than halfway, and it’s had a very positive effect. I don’t know where the stock market is going, but I will say this, that if it continues higher, this will do more to stimulate the economy than anything we’ve been talking about today or anything anybody else was talking about.”
Do we really “underestimate the impact of stock prices on economic activity?” Greenspan’s statement, at first, seems to make sense; but aren’t stock prices a leading economic indicator, a discounting mechanism, reflecting an anticipation of future economic conditions? Or are capital markets a creator and destroyer of economic conditions? If so, what makes stock prices rise or fall?
Consider the logic of this statement:
Stock prices rise when investors anticipate a growing economy; and the economy grows as a result of rising stock prices.
In philosophy, this statement might be considered fallacious logic, or what is called a circular argument; where one assumes in the premises the same that is to be proved in the conclusion. I thought of this circularity when I heard Alan Greenspan speak.
But is this circularity, or might it be something akin to the idea of momentum investing? Furthermore, what was the first mover starting the rise in stock prices in 2009? Was it just hope or was it anticipation of a growing economy? Are there times when stock prices are not actually forecasting economic conditions in the near future; but they are actually creating the capital that stimulates the economy; and hence creating a kind of self-fulfilling prophecy?
So which is it: Are capital markets leading economic indicators or are they leading economic funding for growth? Is it both? Is it sometimes one or the other?
“Nobody goes there anymore; it’s too crowded.” ~ Yogi Berra
This brings to my curious mind another question, which may bring up other questions: If you think the economy is headed for a double-dip recession, and therefore investors are “wrong” for buying into long positions of stock, might this seemingly poor judgment end up fulfilling its own prophecy by enabling economic growth, making these supposed foolish optimists “right” for buying now?
As Barry has said here at TBP before, the crowd is “right” most of the time.
Also, perhaps part of a greater-known investing mantra, “Don’t fight the Fed,” may help answer some of my questions here today: With Greenspan’s statement that stock prices “will do more to stimute the economy,” he implicates the Fed’s wink-wink relationship with Wall Street; to provide fuel for capital markets, which indirectly fuels the growth of the US Economy.
Or perhaps Ben Graham answers some of my questions in his famous assertion: “In the short run, the market is a voting machine but in the long run it is a weighing machine.”
“True wisdom comes to each of us when we realize how little we understand about life, ourselves, and the world around us.” ~ Socrates
Please share your wisdom. I reserved this post idea specifically for you, Barry’s readers, because I knew you would provide a diverse array of wise, educational and/or colorful comments…
What are your thoughts?
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Kent Thune is blog author of The Financial Philosopher.
“”Stock prices rise when investors anticipate a growing economy; and the economy grows as a result of rising stock prices.
In philosophy, this statement might be considered fallacious logic, or what is called a circular argument; where one assumes in the premises the same that is to be proved in the conclusion. “”
Yes, he is saying there is a circular relationship. Often called a feedback loop.
if you are truly interested in diving deeper into this subject I might suggest some study of socionomics.
While Barry may not love his market views, which I understand, he did find Prechter’s Perspective an interesting read and I also think intellectually stimulating. From page 173:
“the market doesn’t ’see into the future,’ as the discounting concept suggests; it records, like a barometer, the causes of the future. Increasingly optimistic poeple expand business; increasingly depressed people contract their businesses. The results show up later as a ‘discounted’ future”
Indeed, there are both inflationary and deflationary feedback loops for the prices of assets:
Let’s say the monetary authorities increase the supply of currency past what is needed to account for any increases in the quantity of good and services demanded. Prices will rise. People will buy now, instead of later. Businesses will expand to meet what appears to be an expansion in demand. Eventually, though, the signals that assets are increasing in value will be muted by increases in their cost structures, and the feedback loop will peter out, at a higher price level, but not at a higher relative value, ceteris paribis. With a severely expansive monetary policy that keeps feeding the loop, output will expand until oversupply becomes so extreme that everything crashes: US 1929; 2009.
It works in reverse for deflationary spirals/feedback loops.
What Greenspan is really saying is that his inflationary monetary policies backfired, and prices crashed in response. He’s also hinting at the connection between herd emotions and economic activity. Herds prefer inflationary feedback loops, because it deludes them into thinking things are getting better, which itself creates a positive feedback loop, spurring economic activity. Herds loath depressing deflationary loops, an emotion that also feeds back into the loop, worsening it. The stock market, in the short run, reflects the herd’s immediate pyschology, which is always looping in small circles enough to make it seem loopy.
Personally I look at it this way.
Stock markets, outside of IPOs are pure casino activity, not really productive economic activity. Yes a rising stock price makes people feel good but companies balance sheets are not affected much by stock prices. Its their sales and debt payments that are most important to their decisions to hire, open another branch/factory etc.
Of course people who are purchasing stocks in the secondary market are doing it with money they dont need for every day consumption. So this is why (I think) there is a huge disconnect between the Dow and the economy at large. People playing in the stock market are using “after consumption” dollars and those who need all they earn to consume wont play in the market. The market has moved with such low volumes lately,is it any surprise? The few people with lots of spare cash are driving the markets right now but they arent creating growth with job creation and adding to the potential buyers of stock. This is why I think this market is likely to crash in the near future, too few buyers. If I want to sell something I like my chances of getting my price if there are 500 people looking at it instead of 5.
George Soros calls these feedback loops “reflexivity”. He thinks this reflexivity should be the main concern of the market participants (regulators included).
Kent, as a CFP you should understand that the majority of wealth for the average U.S. citizen is not created by the returns on their investment portfolio. Wealth is created by disciplined, systematic saving of wages and salaries, frugal consumption, and minimal use of debt. Greenspan’s statement is supporting of the fallacy that true wealth (financial security) and well being can be attained through successful(?) investing in the capital markets. The capital markets have evolved from a realistic means of participating in the growth of the American economy, to a casino where the returns are not necessarily determined by a companies success, but by the a minority group of traders and insiders. It is clear in my mind that Greenspan has a clear case of “pretzel logic.”
There is some feedback. Part is what Keynes called “animal spirits.” Higher prices lead to more confidence, which leads business people to do more, which improves the economy, which leads to higher prices. Part is financial – capital is cheaper for business, so they do more, which improves the economy, which leads to higher prices.
Read Shiller on how bubbles form.
There’s also a wealth effect. I believe the typical projection as around 2%-3% of increased portfolio wealth is spent, which boosts aggregate demand, which improves the economy, which leads to higher prices.
The other thing that’s going on is that the same projections are underlying the market and business. In other words, better animal spirits (or whatever) boosts both the market and the economy.
stock prices rise, net wealth of individuals and corps rise, people/corps spend more, pushes economy positive, drives growth, stock prices rise further, and vice versa; unless i am missing something it’s chicken and egg
You might enjoy pursuing this line of thought by reading Alchemy of Finance (Soros). The key concept that applies is the idea of ‘reflexivity’ (see Adyt above).
I don’t understand why Mr. Thune is even asking these questions, because he himself answered them! Regardless how you call it (circularity, feedback loop, reflexivity) the stock market “feeds” on itself; fear creates more fear, greed – more greed. It works, but only to a point, like a Ponzi scheme. Eventually it reaches mega-bubble levels (such as nasdaq and japanese bubble) that cannot any longer “feed” the real economy, and then it all crashes. The crash takes a lot less time than the building of a bubble, which is why the always bullishly-tilted “crowd” is right most of the time.
Also, regarding the question “what was the first mover starting the rise in stock prices in 2009?” , I think it was exactly the same phenomenon that created a 28% rally from July 2006 until October 2007, all the while RE was crashing, corporate profits were falling, Wall St was running out of cash, and oil priced more than doubled. Namely, it was an implicit (or perhaps even explicit) promise by the Treasury and the Fed to create conditions for the Big Banks to rip profit, hoping that higher stock prices would “trickle down” into real economy. Well, for a while everyone could keep pretending that everything in the economy is OK, simply because the stock market was rising. How did that work out in 2008?
The entire “extend and pretend” policy rests on hope that rising stock market would re-inflate the economy, and Geithner/Bernanke/FRBNY/FASB/Administration are doing everything they can to enable it. This is their first, last and only hope…. and it’s been working for over a year, but IMHO short of 75% devaluation of the USD, in another year or so the market will be back to the March 2009 lows.
but i think conditions have to be decidedly one way to get the anticipated result. process of self-fulfillment between market/economy takes too long relative to number of variables influencing markets, imo
Thank you for such a wonderful question. I hope I can be concise.
Basically, there are two questions here. One deals with pumped stock prices. The other deals with the velocity of money. Greenspan conflates the two in some bizarre and incomprehensible way.
Greenspan was exceptionally wrong when he stated the bit about high stock prices stimulating the economy. Stock prices rise when there is a demand for financial assets. Pumping the price of stock alone, hoping that it will stimulate the economy is an example of trickle down economics. When stock prices alone are stimulated, there is a rush for the cash being used for the pump. Like a flood of water, all boats in the water or near the water rise when the rush first happens and all fall back when the water soaks away. Except for the few who managed to get some of the free money, eventually it all goes away. If you weren’t near the water when it rushed by, you got nothing.
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